Behind the Glass Wall, Part IV

There is a lot hiding inside the question "Will I receive equity for joining/staying at this company?" On the surface it seems reasonable, but I'm suspicious about the way it's asked ("will I receive it?"), as it belies a mental model of a benefit without an associated cost.

Equity is usually purchased or awarded in trade for some other valuable thing. If a company is not yet worth anything, then sure, maybe this nothingness is "awarded" to the founders for free (Note that the incorporation lawyer still extracts a dollar from each founder on behalf of the company for their share allocation, to formalize the explicit value exchange). And let's not forget the fees the lawyer charges the founders for doing a simple name search, filling out and filing the incorporation form, and creating a minute book. You might argue on that basis alone that any business is worth at least the fees required to incorporate it, to say nothing of all the free labour the founders contribute afterward.

You can be sure that new shareholders arriving later will end up having to somehow pony up for all the value-generating activities to date, even though these are not usually made explicit. They show up in the business valuation whenever new investment is sought. This number is quoted by the founders and is usually aspirational, often stretching the limits of the imagination and generating some furtive eye-rolls among potential new shareholders, until the moment one of them believes the valuation to be reasonable enough to buy in, serving as a proof point for the rest.

This series has been exploring the alignment gap between employees and owners, covering the owner mindset, transparency, and compensation in the first three parts. This article is meant to help employees or other non-shareholders think more clearly about the costs and benefits of equity, and the value exchange that occurs when one crosses the chasm from employee to owner. For clarity: by "shareholders" I mean anyone with equity, whether passive investors or active operators. Let's start with a study.

The software agency older than America

In the fall of 1998, just over a year after I began my full-time career as a software developer, my company was acquired by the oldest (by founding date) publicly traded company in the United States. Bowne was founded in 1775, predating Washington's deposition of the British battalion in 1781, and the birth of America itself in 1783 with the signing of the Treaty of Paris.

Bowne logo, circa 2001

Bowne was first listed on the American Stock Exchange in 1968 before moving to the NYSE in 1999. In 1998, four North American companies (including the company I worked for, Mountain Lake Software) were acquired and merged with its software localization unit (Bowne Global Solutions) into a new, larger entity (Bowne Internet Solutions) meant to build websites and localized enterprise software applications for large international clients. The name was later changed to Immersant as a part of a rebranding exercise.

All of the now-familiar hallmarks of a dot-com acquisition were present: the surprising (and welcome) financial payout, the hazy promises of expansion and world domination, the new office space, and to top it all off, an all-expenses-paid trip to Captiva Island off the coast of Florida, where we would meet our new colleagues from around the continent, listen to presentations, play team-formation games, forge our new identity, and eat lots of lobster.

It was an amazing experience for a young software developer. Something like 200 people were airdropped onto the luxury beach resort, given an armband with which to access their rooms and all of the food and drink their hearts desired. Golf carts shuttled everyone around to meetings and playtime activities meant to spark social cohesion. Professional salaries were paid for 3 days for us to build boats out of cardboard and race them into the surf.

I can't imagine the untold sums that must have been spent on that meeting, which of course produced no direct revenue. I'm still wondering who convinced whom to spend the money, but in the end, the Bowne shareholders footed the bill. It was certainly a pricey introduction to our new colleagues and company, but that makes it all the more impressive, from my standpoint: someone thought it important enough to invest in celebrating the milestone, to express a bold new mission, and to seed the culture with nascent connections. Some may see it as excess (and there was certainly some of that), but as a culture hound, I applaud the effort.

During the Q&A portion of one of the Captiva information sessions, one of the newly acquired employees (let's call him "Steve") asked the question from our intro: "Will we be receiving shares as a part of this acquisition?" The answer, in a somewhat amused tone was a clear "no," followed by a further explanation: "We didn't just purchase these businesses for millions of dollars to turn around and give them away."

Now, you may view the question as unremarkable, or following naturally from the context of the meeting, or perhaps even obvious and requiring either a directionally positive response or at least an explanation, owing to the clear need to "motivate employees" to sign on to the new identity and agenda being foisted upon them. You may even view the abrupt answer to be rude.

On the other hand, you may believe the question to be cheeky, and the answer obvious. As you may have guessed from this series' continuing theme, my proposition is that most in the former group are thinking from the employee perspective, while most in the latter are thinking from the owner perspective.

We all understood that Bowne shareholders were motivated to capitalize on the dotcom frenzy that was afoot at the time, but over the next few years, operations were rocky. Customers were expected to pay a premium price, but we didn't have an official premium value proposition. Teams were cobbled together on the basis of having complementary job titles as opposed to real cohesion (predictable with acquisitions, relative to organic growth scenarios). Sales efforts were often disjoint: I was dispatched to foreign cities to join teams of strangers, meeting with prospects without a steering wheel or map.

We tried, and did execute some major new projects successfully, but eventually became victims of the dotcom bubble implosion. To be fair to Immersant, the market seemed to realize en masse that the digital services industry as a whole was delivering less than it was promising, and we weren't the only casualties.

Immersant was shuttered in 2001. By this time, Bowne shareholders had been keenly feeling the pinch for some time. Bowne had paid boomtime prices for each of the four acquired companies, and costs had outpaced the revenues required to justify continued attempts to recoup that investment.

Who Paid for the Lobster?

So what can we learn from all of this?

Bowne shareholders acquired the companies comprising Immersant by buying them, making a financial bet on the growth of the new entity and industry without any guarantee of a reward. When it didn't work out, they experienced the loss of that investment capital, revealing the very real embedded risk all shareholders assume, leashed to an uncertain future. This showed up as a concomitant drop in the value of their shares (purple highlighted section below). And on the cost side of the early ledger, of course, was the Captiva Island junket.

Bowne stock chart, 1998 to 2010. Image created by Gemini.

Steve (and most of us) would prefer to be "awarded" shares to cash in on future gains, because it feels like a risk-free reward with potential upside. We muse about the vague potential of a future equity payout, but we often forget to contemplate how governance, costs, debt, dilution, non-performance, and market sentiment also affect shareholder interests. But the negative outcome experienced by Bowne shareholders makes it easy to see how equity cuts both ways. It's not likely that Steve was thinking about any of this. I certainly wasn't, owing perhaps to the butter-soaked lobster claw in my non-shareholder hands at the time.

Equity is distinct from other compensation incentives, including stock options, profit-sharing, or performance bonuses, all of which are more straightforwardly positive owing to their lack of downside exposure. However, equity shouldn't be viewed as an incentive for good work, or a bonus for agreeing to join a company. It's an entry in a ledger bundling your interest in both the gains and the losses of a company with variable performance.

In 2010, Bowne itself was acquired by RR Donnelley and taken private at a value 65% higher than the market cap at the time. This was quite close to the valuation just before Mountain Lake and the others were acquired, making me wonder if the whole thing was just a dream.

Hidden treasures

Lost investments, missed opportunities, and failed companies result when things don't go well. When things unfold more positively, however, the downside risk doesn't manifest as loss: it turns into value. Non-shareholders tend to undervalue and forget about this risk, since they never lived through it.

Also easily missed is the compounding value of networked successes. As a trivial example, after having simply incorporated and printed business cards, Jonah Group could boldly proclaim to the market that "We have a software consulting company whose founders have multiple decades of combined software development experience, having worked with companies X and Y in the past to do thing Z, which we're now quite good at. Here's my card." We could now make the claim of an operating entity, proven by the business cards that most never print, the company most never register, the insurance most never buy, and (as they started to trickle in) the customers most never win. And it's much easier to sell to new customers when you can point to some old ones.

These and countless other intangible networked effects accrue to "goodwill," an accounting term covering brand reputation, customer relationships, employee expertise, and proprietary processes, among other things. They are easy to miss, because they have no obvious physical manifestation. This isn't the bricks or machines, but it's what makes customers keep coming back. Coca Cola lists USD $18.1B of goodwill on its balance sheet at the time of this writing. I like to think of as this as the value of billions of people smiling when they think of a drinking a Coke.

"Have a Coke and a smile" 1970s Coca-Cola commercial

Non-shareholders tend to miss these hidden treasures when thinking about businesses. Late in Jonah Group's history, one of our directors told me offhandedly that, "At this point, the company runs itself." He wasn't being arrogant; just factual. We had successfully transitioned most of delivery operations to the Director level, and we enjoyed a decent quorum of repeat business. We'd survived for 20 years, piloting through dangerous waters, stacking network effects, and avoiding near-misses.

Make no mistake, though: the price was paid with sweat and worry, and is embodied within the scars on the collective psyches of the shareholders. And the value of successfully navigating those waters inures to the risk takers.

Image generated by Gemini

The power of purchase

Existing shareholders are diluted whenever new ones are added. They'll support this if they believe that the newcomers will expand the pie to compensate for the reduction in the relative size of their slice. Note that if they do believe this, they'd be silly not to offer the equity. This isn't generosity; merely simple math.

In this regard, Neither Steve nor anyone else had yet convinced the Bowne shareholders or leadership of their ability (or willingness to try) to achieve this, nor had Steve offered to accept a pay cut in return for a slice of the pie.

When a company sells shares on the public market (during an IPO or subsequent issuance), the money it receives embodies the full value of the new equity participation. The share price alone must represent this value since the purchaser isn't promising to help build value afterward.

Private companies offer you two ways in: pay cash now, or accept a reduction in your earnings over time. If shares are gifted or discounted, there is always some other less obvious benefit that those making the offer expect to receive. Some offer options instead, which are coupons to buy shares in the future at an agreed price. Employees usually commit to staying at the company for some length of time (the vesting period) before they can be exercised, which is decidedly the point.

Buying in (either with cash or via a reduction in earnings) snaps you into alignment with the legacy shareholders in a way that receiving options or simply committing to stay at a company (a decision that can be easily reversed) does not. Purchasing shares proves to legacy shareholders that you believe in your own ability to increase the share value beyond the purchase price. You have "skin in the game," leading all of the other shareholders in that belief.

You'll never feel fully responsible for the success or failure of a business without this initial outlay. We value the things we pay for more highly relative to those that we receive for free, and we pay attention to things that we value. This attention is critical to steering the ship through the darkness. For this reason, I believe it's a mistake to ever award equity in a company that already has value. If Immersant employees had been gifted equity when the company was formed, they would never have fully felt the urgency to succeed that only comes from placing value at risk, further devaluing the gift from the legacy shareholders' perspective.

Shareholders implicitly value each others' opinions and input more highly than that of non-shareholders, because their perspective is continuously tempered by the shared value they have at risk. They assume other shareholders will do their best to protect and expand share value, just as they do.

From the belly of the whale

It's true that Immersant employees lost their jobs in 2001, which I don't want to minimize (I was one of them), but since we were not shareholders, we didn't lose any invested capital. When the company shut down, employees were awarded severance packages (also paid for by Bowne shareholders). This gave us little bit of a financial cushion, which my new partners and I (all ex-Mountain Lake) used to launch Immersant's successor: Jonah Group, so named because we were "swallowed by the whale and spit out again" relatively intact.

Jonah group logo, circa 2022

Owing to our history, we were fairly suspicious of stock option plans and promises that could be interpreted as empty, depending on who was in charge. As such, to motivate employee performance we chose a simple profit-sharing plan based on both individual and company performance relative to target. We generally invested some of the earnings in growth (office space, staff, computers), and saved some to act as a buffer during lean times, a prudent decision, as it turned out on more than one occasion.

At each year end, we would pay out the remainder of the company's earnings in staff bonuses and shareholder dividends, not knowing (or even expecting) that we would continue to be successful over the long term. Equity gave us decision-making authority, but the prospect that the equity itself might appreciate wasn't really a consideration early on.

We had traded all of our time and a regular paycheck for the Jonah shares, but even then I didn't really appreciate the implication of what we had decided to embark upon together. There was nothing much at risk: we had contributed $10K each for sundry startup expenses, which my Immersant severance had funded.

You may think me naïve (I was), but I distinctly remember the moment I realized that the founders, including me, were going to have to be responsible for attracting new clients and revenue. It happened during our first sales meeting with a customer, during which I finally noticed that no-one else was sitting on our side of the table!

Each week, the risk of being a founder became more apparent, and I started to feel it in my bones. The anxiety of "now what?" quickly took up residence in our minds at our weekly coffee shop status meetings. I was used to "doing a good job and getting paid," but now we had to redefine what a "good job" even was, and somehow prove to prospective clients (a.k.a. strangers) that we could indeed "do that." A service-based business feels like an unending job interview, except here your resume doesn't help you.

I promise you that my initial forays into sales were baldly inept. I would show up to any meetings with whomever would agree to one, even if it was with someone from the [gasp!] procurement department. Instead of engaging in rapport-building conversation, I would sheepishly introduce Jonah by name, race through a bulleted service list, and slide my little folder of amateur materials across the desk, enjoining them to read and digest it on their own, finally ending this painful marathon of self-promotion, for god's sakes!

It really wasn't that bad, but it sure felt grueling at the time, which I suppose is why many people don't do this.

Structural misalignment

17 years into the experiment, we had become much better sales people. And the company had grown to about 125 team members by the time began to think about succession. We hired a consulting company to help us navigate a potential transition. We were advised to choose a 3-year period where financial performance was consistently strong and heading in a positive direction before taking the company to market. To try to make this happen strategically rather than hope for it organically, we finally did end up offering equity to our most trusted senior staff, thinking that this would motivate them to hunker down and help us do this.

We offered 10% of the shares of the company at a 30% discount relative to a conservative company valuation, to sweeten the deal for what we hoped might become the next generation of company leaders. We also offered a gradual earnout mechanism for receiving the shares, allowing our people to use a part of their bonuses each year so that an initial cash outlay wouldn't be necessary.

We were proud of the work we did to make the offer a reality. In addition to rewarding them for their participation, we hoped that this step would produce alignment, bringing them closer to us in the context of leading the business to future success. As owners, our thought process was something like "if you believe this business is a going concern, which it has been for the last 19 years at an annualized growth rate of about 10%, it would make sense to invest in the company in exchange for what should amount to a 40% return (30% discount plus the prospect of 10% growth) in the first year alone, notwithstanding the risk associated with the illiquidity of shares in a private entity."

In the end, none of them took us up on the offer. As it turns out, the thought process for our trusted senior staff was markedly different. And even those who had over the years claimed that they might be interested in taking the reins in the future didn't bite.

It's likely they didn't believe the company was a good investment, at least not relative to others they could have made, or did make, instead. Though this felt like a personal rejection of sorts at the time, we understood that everyone's personal calculus was valid, even if different from ours.

Further discussion helped us better appreciate some of the reasons they didn't proceed, which turned out to be distinct for each person. Some were worried about certain risks in the business, which we'd already lived with for many years. Some wanted to ruminate for a longer period, which we'd also been doing for years. One even said they would have pulled the trigger if we'd offered them a much larger stake in the company, as opposed to the initial tranche we'd conceived of, exposing the limits of profit-sharing without decision-making power. We didn't anticipate any of this.

We switched to a plan in which we awarded our most senior staff fully vested stock options, baking the 30% discount into the strike price, but stipulating that they'd lose them if they decided to leave the company. Despite this, almost all of the options remained un-exercised when we later sold the business in September of 2022, just after the company's 21st birthday. The friction and cost of exercising the options was still a real hurdle. And though they eventually still received the payout, they lost the tax benefit that could have been.[1]

Despite all this, the process as a whole generated clarity. The equity offer was more than a proposal—it was a mirror. It forced people to confront risk they'd never actually weighed. Risk awareness isn't automatic; it's triggered by the possibility of exposure. Employees understand risk abstractly, but shareholders understand it viscerally.

Declining the opportunity to buy into the business exposed the alignment gap, and valuing the shares, making the offer, and getting no takers uncovered it. The Founders' belief in the company was already explicit and obvious, albeit having been earned in the past. Perhaps our senior staff would have got there given more time. In any case, as the founders approached retirement age, it helped clarify the eventual decision to sell the company on the private market, without the discount.

The unbridgeable divide

Photo by Leo_Visions on Unsplash

It has always seemed ironic to me that the people charged with delivering a successful product or service (the employees) are (for the most part) not the same people who stand to gain from that success, but alas this is the situation with all public companies, and most private ones.

Further, employees generally favour increasing salaries, benefits, and company investments in staff intangibles, while concurrently avoiding layoffs. But they generally ignore concerns about profitability, since they don't fully participate in company earnings. How can they be expected to be motivated to keep the business alive and healthy without feeling the risk of loss or benefit of profit that accrues to shareholders?

A parallel irony is that (non-employee) shareholders are given the responsibility of voting on all of the major decisions (!) the company should take. If you've ever owned any shares in a public company that you don't work at, you've probably experienced the absurdity of this. You have very little to do with the day to day operations of the business, and probably have little to no clue about what it takes to make it successful.

How many Bowne shareholders really understood the business of financial printing, to say nothing of the software consulting businesses that they all voted to acquire? How can non-expert, non-participants possibly be expected to make optimal decisions on the company's behalf, superseding the judgement of the very people who work there?

At the extremes, employees feel like cogs in a machine and care nothing about company health and profit, while shareholders never experience the ground truth of operation, viewing people as profit-generating entries on a spreadsheet.

On the other hand, owner/operators generally have technical expertise, business familiarity, and significant value at risk. This allows them to properly optimize decisions, strategy, and direction. For example, an owner/operator might decide that earnings can take a hit in the short term in favour of investments in staff growth or customer retention, with the assumption that this will show up as future earnings in the long term. The owner/operator is the right person to balance these competing forces.

This begs the question "should employees always be shareholders in the companies they work for?" After all, "alignment" is the glittering prize that drives success. Achieving it would finally put an end to the ironies above, alleviating the canonical "management / labour" friction of the modern workplace. It could motivate participation in overtime, obviate the need for processes like performance reviews, and expand the effective sales force.

Law practices are often organized around this model, with each partner managing a book of business and voting on admitting up-and-comers into the fold. Associates are viewed as "partners in training."

Forcing equity ownership might create its own set of problems, however, not the least of which is that relatively few people want to contend with the risks of ownership, preferring instead to simplify their lives by contributing to a cause rather than being responsible for it. The Jonah Group equity offer story seems to exemplify this. Throughout this series, I've proposed thinking and acting like an owner even when you aren't one. In the end, however, the alignment gap is structural. Unless employees are also shareholders, it may never be fully bridged.

The Odyssey

The point of this article, however, is not to encourage you to become an owner, nor to advise that you remain an employee. It's to reveal the stakes to help you decide for yourself.

Know that becoming a founder or shareholder means you'll have to commit something. It's easier to commit what you have: effort if you're a founder without cash, or cash if you're an investor that doesn't want to expend effort. Or some combination of the two if you are a shareholder employee. This commitment produces visceral alignment in a way that idly thinking about risks and rewards does not. Showing up to the poker table with your own chips proves that you're a player. A gifted stack just makes you reckless.

If you're ready, start looking for opportunities to either "buy in" or earn the shares. Or start with founder shares valued at $1 and fully bet on yourself and your fellow founders. Make no mistake, however: in this world, you are Odysseus, lashing yourself to the mast. Brace yourself for the inevitable and unyielding math. But also know there's a good chance that you'll receive a boon when you return from your hero's journey.

Footnotes

[1] Capital gains are taxed at a lower rate than income. Governments decide which is which in part by how long you've held the shares.

References

• Bowne & Co. founding in 1775: CultureNow

• Treaty of Paris (1783): Wikipedia

• Bowne Internet Solutions acquisition: Fast Company

• Immersant shuttered (2001): What They Think

• RR Donnelley acquires Bowne (2010): Reuters

• Coca-Cola goodwill ($18.1B): SEC 10-K Filing

• Stock options explained: Wikipedia

• Jonah Group (archived): Web Archive